Friday, October 3, 2008

Who Caused the Economic Crisis?

MoveOn.org blames McCain advisers. He blames Obama and Democrats in Congress. Both are wrong.

AMoveOn.org Political Action ad plays the partisan blame game with theeconomic crisis, charging that John McCain’s friend and formereconomic adviser Phil Gramm “stripped safeguards that would haveprotected us.” The claim is bogus. Gramm’s legislation hadbroad bipartisan support and was signed into law by President Clinton.Moreover, the bill had nothing to do with causing the crisis, andeconomists – not to mention President Clinton – praise itfor having softened the crisis.

A McCain-Palin ad, in turn, blames Democrats for the mess. The ad saysthat the crisis “didn’t have to happen,” becauselegislation McCain cosponsored would have tightened regulations onFannie Mae and Freddie Mac. But, the ad says, Obama "was notablysilent" while Democrats killed the bill. That’s oversimplified.Republicans, who controlled the Senate at the time, did not bring thebill forward for a vote. And it’s unclear how much thelegislation would have helped, as McCain signed on just two monthsbefore the housing bubble popped.

In fact, there’s ample blame to go around. Experts have citedeveryone from home buyers to Wall Street, mortgage brokers to AlanGreenspan.

The MoveOn.org Political Action ad blames a banking deregulation billsponsored by former Sen. Phil Gramm, a friend and one-time adviser toMcCain's campaign. It claims the bill "stripped safeguards that wouldhave protected us."

That claim is bunk. When we contacted MoveOn.org spokesman TrevorFitzgibbons to ask just what "safeguards" the ad was talking about, hecame up with not one single example. The only support offered for thead's claim is one line in one newspaper article that reported the bill"is now being blamed" for the crisis, without saying who is doing theblaming or on what grounds.

The bill in question is the Gramm-Leach-Bliley Act,which was passed in 1999 and repealed portions of the Glass-SteagallAct, a piece of legislation from the era of the Great Depression thatimposed a number of regulations on financial institutions. It's truethat Gramm authored the act, but what became law was a widely acceptedbipartisan compromise. The measure passed the House 362 - 57, with 155 Democrats voting for the bill. The Senate passed the bill by a vote of 90 - 8.Among the Democrats voting for the bill: Obama's running mate, JoeBiden. The bill was signed into law by President Clinton, a Democrat.If this bill really had "stripped the safeguards that would haveprotected us," then both parties share the blame, not just "JohnMcCain's friend."

The truth is, however, the Gramm-Leach-Bliley Act had little ifanything to do with the current crisis. In fact, economists on bothsides of the political spectrum have suggested that the act hasprobably made the crisis less severe than it might otherwise have been.

Last year the liberal writer Robert Kuttner, in a piece in The American Prospect, arguedthat "this old-fashioned panic is a child of deregulation." But even hedidn't lay the blame primarily on Gramm-Leach-Bliley. Instead, hedescribed "serial bouts of financial deregulation" going back to the1970s. And he laid blame on policies of the Federal Reserve Board underAlan Greenspan, saying "the Fed has become the chief enabler of adangerously speculative economy."

What Gramm-Leach-Bliley did was to allow commercial banks to get into investment banking. Commercialbanks are the type that accept deposits and make loans such asmortgages; investment banks accept money for investment into stocks andcommodities. In 1998, regulators had allowedCiticorp, a commercial bank, to acquire Traveler's Group, an insurancecompany that was partly involved in investment banking, to formCitigroup. That was seen as a signal that Glass-Steagall was a deadletter as a practical matter, and Gramm-Leach-Bliley made its repealformal. But it had little to do with mortgages.

Actually, deregulated banks were not the majorculprits in the current debacle. Bank of America, Citigroup, WellsFargo and J.P. Morgan Chase have weathered the financial crisis inreasonably good shape, while Bear Stearns collapsed and Lehman Brothershas entered bankruptcy, to name but two of the investment banks whichhad remained independent despite the repeal of Glass-Steagall.

Observers as diverse as former Clinton Treasury official and current Berkeley economist Brad DeLong and George Mason University's Tyler Cowen, a libertarian, have praised Gramm-Leach-Bliley has having softened the crisis. The deregulation allowed Bank of America and J.P. Morgan Chase to acquire Merrill Lynch and Bear Stearns. And Goldman Sachs and Morgan Stanley have now converted themselves into unified banks to better ride out the storm. That idea is also endorsed by former President Clinton himself, who, in an interview with Maria Bartiromo published in the Sept. 24 issue of Business Week, said he had no regrets about signing the repeal of Glass-Steagall:

Bill Clinton (Sept. 24):Indeed, one of the things that has helped stabilize the currentsituation as much as it has is the purchase of Merrill Lynch by Bank ofAmerica, which was much smoother than it would have been if I hadn'tsigned that bill. ...Youknow, Phil Gramm and I disagreed on a lot of things, but he can'tpossibly be wrong about everything. On the Glass-Steagall thing, like Isaid, if you could demonstrate to me that it was a mistake, I'd be gladto look at the evidence. But I can't blame [the Republicans]. Thiswasn't something they forced me into.

No, Blame the Democrats!

The McCain-Palin campaignfired back with an ad laying blame on Democrats and Obama. Titled"Rein," it highlights McCain's 2006 attempt to "rein in Fannie andFreddie." The ad accurately quotes the Washington Post assaying "Washington failed to rein in" the two government-sponsoredentities, the Federal National Mortgage Association ("Fannie Mae") andthe Federal Home Loan Mortgage Corporation ("Freddie Mac"), both ofwhich ran into trouble by underwriting too many risky home mortgages tobuyers who have been unable to repay them. The ad then blames Democratsfor blocking McCain's reforms. As evidence, it even offers a snippet ofan interview in which former President Clinton agrees that "theresponsibility that the Democrats have" might lie in resisting his ownefforts to "tighten up a little on Fannie Mae and Freddie Mac." We'rethen told that the crisis "didn't have to happen."

It's true that key Democrats opposed the Federal Housing Enterprise Regulatory Reform Act of 2005,which would have established a single, independent regulatory body withjurisdiction over Fannie and Freddie – a move that theGovernment Accountability Office had recommended in a 2004 report. Current House Banking Committee chairman Rep. Barney Frank of Massachusetts opposed legislation to reorganize oversightin 2000 (when Clinton was still president), 2003 and 2004, saying ofthe 2000 legislation that concern about Fannie and Freddie was"overblown." Just last summer, Senate Banking Committee chairman ChrisDodd called a Bush proposal for an independent agency to regulate the two entities "ill-advised."

Butsaying that Democrats killed the 2005 bill "while Mr. Obama was notablysilent" oversimplifies things considerably. The bill made it outof committee in the Senate but was never brought up for consideration.At that time, Republicans had a majority in the Senate and controlledthe agenda. Democrats never got the chance to vote against it or tomount a filibuster to block it.

By the time McCain signedon to the legislation, it was too late to prevent the crisis anyway.McCain added his name on May 25, 2006, when the housing bubble hadalready nearly peaked. Standard & Poor's Case-Schiller Home Price Index,which measures residential housing prices in 20 metropolitan regionsand then constructs a composite index for the entire United States,shows that housing prices began falling in July 2006, barely two monthslater.

The Real Deal

So who isto blame? There's plenty of blame to go around, and it doesn't fastenonly on one party or even mainly on what Washington did or didn't do.As The Economist magazine noted recently,the problem is one of "layered irresponsibility ...with hard-working homeowners and billionaire villains eachplaying a role." Here's a partial list of those alleged to be at fault:

The Federal Reserve, which slashed interest rates after the dot-com bubble burst, making credit cheap.

Home buyers, who took advantage of easy credit to bid up the prices of homes excessively.

Congress, which continues to support a mortgage tax deduction that gives consumers a tax incentive to buy more expensive houses.

Real estate agents, most of whom work for the sellers rather than the buyers and who earned higher commissions from selling more expensive homes.

The Clinton administration, which pushed for less stringent credit and downpayment requirements for working- and middle-class families.

The Bush administration, which failed to provide needed government oversight of the increasingly dicey mortgage-backed securities market.

An obscure accounting rulecalled mark-to-market, which can have the paradoxical result of makingassets be worth less on paper than they are in reality during times ofpanic.

Collective delusion,or a belief on the part of all parties that home prices would keeprising forever, no matter how high or how fast they had already goneup.

TheU.S. economy is enormously complicated. Screwing it up takes a greatdeal of cooperation. Claiming that a single piece of legislation wasresponsible for (or could have averted) is just politicalgrandstanding. We have no advice to offer on how best to solve thefinancial crisis. But these sorts of partisan caricatures can only makethe task more difficult.

–by Joe Miller and Brooks Jackson

Sources

Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered. Oxford University Press, 1990.